Diversification Explained

What is Diversification?

A great presentation about the benefits of diversification is presented by Charles Schwab as they develop their “Intelligent Portfolio” for small net worth individuals. While they present a compelling case, the fact is, it results in a portfolio that consists of 19 securities! Try building and maintaining that with your $400 monthly investment.

And, the performance comes no where near a simple investment in VTI.

Diversification by Asset Class

Many financial advisors recommend that your portfolio be diversified by asset class. That is, have your funds distributed among several, non-correlated classes of assets.

Examples of asset classes are

domestic stocks

international stocks

emerging markets stocks

bonds,

real estate,

precious metals,

commodities,

cash.

Diversification by Sector

Another type of portfolio diversification is diversification by sector of the economy. The idea is that an investor should distribute his money among several sectors of the economy. Here are the sectors, serveral of which should be represented in your diversified portfolio.

Consumer Discretionary (12 Industries)

Consumer Staples (6 industries)

Energy (2 industries)

Financials (8 industries)

Health Care (6 industries)

Industrials(14 industries)

Information Technology (8 industries)

Materials (5 industries)

Telecommunication Services (2 industries)

Utilities (5 industries)

Diversification by Market Capitalization and Style

Finally, there is the idea of diversification by Market Cap (total value of a companies outstanding shares); “cap” is shorthand for capitalization. Reading from left to right, top to bottom, the Market Barometer represents the performance of:

Principle Behind Diversification

The idea is that not all asset classes, sectors, and categories will be moving in the same direction at the same time. By having your assets distributed among several asset classes, sectors and/or categories, the violent swings of the market will be dampened. You own both the zigs and the zags.

The Callan Periodic Table

One of the strongest arguments for a Diversified Portfolio is a table developed by Callan Associates which presents different asset classes and styles ranked each year by their performance.

The above table demonstrates conclusively that there is no one asset class or sector that is consistently up or down (just have a look at MCSI Emerging Markets). The distribution of returns is obviously random. The conventional wisdom is that in order to have a strong portfolio, one’s portfolio should be invested in several of the categories.

The Diversified Portfolios of Future Advisors

Future Advisors is an investment advisory firm that advocates a highly diversified portfolio and they will help you (for a fee) construct a diversified portfolio that “they think” is a good one. Below are their rationales for including the various asset classes that they do.

Stocks

Domestic Stock

US Domestic Stock takes up more room in the portfolio than any other asset class because of it’s incredible long-term historical returns.

Foreign Stock

Stocks in companies based in other developed countries allow US-based investors to receive equity-level returns while diversifying across geographies.

Emerging Markets Stock

Funds that invest in countries with an emerging economy, such as China, Brazil, India, and Russia play a small but important role in our portfolio strategy.

Real Estate Investment Trusts

Experts recommend [3] Real Estate Investment Trusts (REITs) be included in a long-term portfolio to add more diversification than domestic and international stocks can deliver alone. REITs are funds that invest in companies whose primary income comes from owning buildings and land, thus participating in the long-term growth of real estate prices.

Small Cap & Value

Research has found that small cap stocks and value stocks significantly outperform the market as a whole over the long run, both in the U.S. and abroad. Therefore, our asset class recommendations have a small cap and value lean. Fama, E.; French, K. (1993)

Bonds

Investment Grade Bonds

Investment-grade corporate bonds as well as US Treasury and Agency bonds provide a measure of safe haven in turbulent markets as well as diversified growth in bear markets.

Inflation Protected Bonds

Treasury Inflation Protected Securities (TIPS) are unique Treasury Bonds whose coupon payments increase as inflation increases. They provide unique pure protection against inflation, while also being a safe haven in times of crisis due to their credit quality.

References and Citations:

The recommended portfolio for each risk tolerance and age is built with an equity / bond split corresponding to the Morningstar LifeCycle Investing Glide Path Index. This work on Lifecycle Asset Allocation is itself based on prior literature from, among others, Chen, Ibbotson, Milevsky, and Zhu [2006, 2007] as well as Bodie, Merton, and Samuelson [1992] and Viceira [2002]. For a more complete discussion refer to “Ibbotson SBBI 2010 Classic Yearbook “Market Returns for Stocks, Bonds, Bills, and Inflation 1926-2009”. Chicago: Morningstar, 2010. Print.”

The choice of these four core equity asset classes, two core bond classes, and their relative weights is based on the model portfolio built by David Swensen, the head of the Yale University Endowement. For a further discussion of each asset class please see “Swensen, David S. Unconventional Success: A Fundamental Approach to Personal Investing. New York: Simon & Schuster, 2005. Print.”

The case for the inclusion of REITs in the recommended portfolio is eloquently presented by, among others, Larry Swedroe and David Swensen. Previous academic research by, among others, Chen et al (2005) and Kuhle (1987) shows that historically the inclusion of REITs in an otherwise equity portfolio has added diversification value. For a further discussion of REITs and their role in a long-term portfolio see “Chen, Hsuan-Chi et. al. Real Estate Investment Trusts. The Journal of Portfolio Management. 2005, Vol. 31, No. 5: pp. 46-54″ and “Kuhle, James L. Portfolio Diversification and Return Benefits–Common Stock vs. Real Estate Investment Trusts (REITs). Journal of Real Estate Research. 1987, Vol. 2, Issue 2.